What is Break Even Analysis?
Break Even Analysis in economics, business, and cost accountingFinancial Accounting TheoryFinancial Accounting Theory explains the "why" behind accounting - the reasons why transactions are reported in certain ways. This guide will help you understand the main principles behind Financial Accounting Theory refers to the point in which total cost and total revenueSales RevenueSales revenue is the starting point of the income statement. Sales or revenue is the money earned from the company providing its goods or services, income are equal. A break even point analysis is used to determine the number of units or revenue needed to cover total costs (fixed and variable costsFixed and Variable CostsFixed and variable costs are important in management accounting and financial analysis. Fixed costs do not change with increases/decreases in units of production volume, while variable costs are solely dependent on the volume of units of production. This guide teaches an analyst the fixed vs variable cost methods).
Formula for Break Even Analysis
The formula for break even analysis is as follows:
Break even quantity = Fixed costs / (Sales price per unit – Variable cost per unit)
Where:
- Fixed costs are costs that do not change with varying output (i.e. salary, rent, building machinery).
- Sales price per unit is the selling price (unit selling price) per unit.
- Variable cost per unit is the variable costs incurred to create a unit.
It is also helpful to note that sales price per unit minus variable cost per unit is the contribution margin per unit. For example, if a book’s selling price is $100 and its variable costs are $5 to make the book, $95 is the contribution margin per unit and contributes to offsetting the fixed costs.
Example of Break Even Analysis
Colin is the managerial accountant in charge of Company A, which sells water bottles. He previously determined that the fixed costs of Company A consist of property taxes, a lease, and executive salaries, which add up to $100,000. The variable costs associated with producing one water bottle is $2 per unit. The water bottle is sold at a premium price of $12. To determine the break even point of Company A’s premium water bottle:
Break even quantity = $100,000 / ($12 – $2) = 10,000
Therefore, given the fixed costs, variable costs, and selling price of the water bottles, Company A would need to sell 10,000 units of water bottles to break even.
Graphically Representing the Break Even Point
The graphical representation of unit sales and dollar sales needed to break even is referred to as the Break even chart or CVP graph. Below is the CVP graph of the example above:
Explanation:
- The number of units is on the X-axis (horizontal) and the dollar amount is on the Y-axis (vertical).
- The red line represents total fixed costs of $100,000.
- The blue line represents revenue per unit sold. For example, selling 10,000 units would generate 10,000 x $12 = $120,000 in revenue.
- The yellow line represents total costs (fixed and variable costs). For example, if the company sells 0 units, the company would incur $0 in variable costs but $100,000 in fixed costs for total costs of $100,000. If the company sells 10,000 units, the company would incur 10,000 x $2 = $20,000 in variable costs and $100,000 in fixed costs for total costs of $120,000.
- The break even point is at 10,000 units. At this point, revenue would be 10,000 x $12 = $120,000 and costs would be 10,000 x 2 = $20,000 in variable costs and $100,000 in fixed costs.
- When the number of units exceeds 10,000, the company would be making a profit on the units sold. Note that the blue revenue line is greater than the yellow total costs line after 10,000 units are produced. Likewise, if the number of units is below 10,000, the company would be making a loss. From 0-9,999 units, the total costs line is above the revenue line.
Interpretation of Break Even Analysis
As illustrated in the graph above, the point at which total fixed and variable costs equal to total revenues is known as the break even point. At the break even point, a business does not make a profit or loss. Therefore, the break even point is often referred to as the ‘no-profit’ or ‘no-loss point.’
The break even analysis is important to business owners and managers in determining how many units (or revenues) are needed to cover fixed and variable expenses of the business.
Therefore, the concept of break even point is as follows:
- Profit when Revenue > Total Variable cost + Total Fixed cost
- Break-even point when Revenue = Total Variable cost + Total Fixed cost
- Loss when Revenue < Total Variable cost + Total Fixed cost
Sensitivity Analysis
Break even analysis is often a component of sensitivity analysisWhat is Sensitivity Analysis?Sensitivity Analysis is a tool used in financial modeling to analyze how the different values for a set of independent variables affect a dependent variable under certain specific conditions. Sensitivity Analysis is performed in Excel to asses risks, measure potential outcomes, and plan for an uncertain future and scenario analysisScenario AnalysisScenario analysis is a technique used to analyze decisions through speculating various possible outcomes in financial investments. In financial modeling, this process is typically used to estimate changes in the value of a business or cash flow. By using the Choose or Offset functions an analyst can crease base case performed in financial modelingWhat is Financial ModelingFinancial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model. A 3 statement model links income statement, balance sheet, and cash flow statement. More advanced types of financial models are built for valuation, plannnig, and. Using Goal SeekGoal SeekThe Goal Seek Excel function (What-if-Analysis) is a method of solving for a desired output by changing an assumption that drives it. The function uses a trial and error approach to back-solving the problem by plugging in guesses until it arrives at the answer. It is used for performing sensitivity analysis in Excel in Excel, an analyst can backsolve how many units need to be sold, at what price, and at what cost to break even.
Learn more, in CFI’s financial modeling courses.
Related Readings
CFI is a leading provider of financial analysis coursesFMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy. for investment banking professionals. To help you advance your career, check out the additional resources below:
- CVP GuideCVP Analysis GuideCost Volume Profit (CVP analysis), also commonly referred to as Break Even Analysis, is a way for companies to determine how changes in costs (both variable and fixed) and sales volume affect a company’s profit. With this information, companies can better understand overall performance
- How the 3 Financial Statements are LinkedHow the 3 Financial Statements are LinkedHow are the 3 financial statements linked together? We explain how to link the 3 financial statements together for financial modeling and valuation in Excel. Connections of net income & retained earnings, PP&E, depreciation and amortization, capital expenditures, working capital, financing activities, and cash balance
- Cot Behavior AnalysisCost Behavior AnalysisCost behavior analysis refers to management’s attempt to understand how operating costs change in relation to a change in an organization’s level of activity. These costs may include direct materials, direct labor, and overhead costs that are incurred from developing a product.
- Analysis of Financial StatementsAnalysis of Financial StatementsHow to perform Analysis of Financial Statements. This guide will teach you to perform financial statement analysis of the income statement, balance sheet, and cash flow statement including margins, ratios, growth, liquiditiy, leverage, rates of return and profitability. See examples and step-by-step instruction